With the cost of some private colleges now exceeding $40,000 a year, paying for higher education has become even more challenging for parents and grandparents.

Grandparents: Multiply a Gift Tax
Break for Prepaid Tuition

In a new private letter ruling, the IRS has approved a way to meet the skyrocketing costs of education for your grandchildren while reducing the size of your taxable estate — all in one shot. (IRSPLR 200602002) Background: In general, you don’t have to pay federal gift tax on transfers under the annual gift tax exclusion. For 2006, you can give each recipient as much as $12,000 ($24,000 if your spouse joins in the gift). If you exceed the annual amount, the gift may be sheltered from tax by the lifetime $1 million gift tax exemption, but this will erode your available estate tax shelter.
Fortunately, you can help your grandchildren without resorting to these measures. If you pay a child’s tuition directly to an eligible school, the amount is exempt from gift tax in addition to any transfers covered by the annual gift tax exclusion. Therefore, you can pay a child’s college or private school tuition for the entire year — with no gift tax complications.
The new IRS ruling extends this tax break further. It allowed a taxpayer to pay tuition bills for each of his six grandchildren through the twelfth grade in a single payment. Since the taxpayer isn’t entitled to any discounts and fully relinquished all rights to the funds, the entire transfer is exempt from gift tax, the IRS ruled.
In other words, you can make tuition payments for multiple years completely free of gift tax. This can be beneficial for affluent grandparents who want to reduce their taxable estates.Caution: You might forfeit funds if the child doesn’t attend the school or transfers to another school. Alternatively, if you make a payment with strings attached (such as the school refunding the money if the child doesn’t enroll), the IRS could rule that it constitutes a taxable gift. Consult with your tax adviser to see if this technique could work for you.

College Savings Plans: New Law
Offers a Dose of Relief

The new Deficit Reduction Act of 2005, which was signed into law in February, includes provisions that may encourage the use of college saving programs. Here’s a brief summary for parents diligently setting aside money:Transfers to Section 529 Plans - The new law clarifies that amounts transferred to a Section 529 College Savings Plan from a child’s custodial account won’t be treated as a student asset for financial aid purposes. Under the complex federal calculations used to qualify for need-based financial aid, assets owned by a student count more heavily than assets owned by the parents.Prepaid Tuition Plans - Previously, funds in a Prepaid Tuition Plan were treated as assets owned by the student for federal financial aid purposes. But the funds in a 529 College Savings Plan were characterized as assets of the parents, giving those plans a decided edge. Now the new law has leveled the playing field: Assets in both types of plans are treated as parental assets.
This change is expected to boost interest in Prepaid Tuition Plans, which currently aren’t as widely used as 529 College Saving Plans, but don’t have the same investment risks. Less than half the states have Prepaid Tuition Plans, while all 50 states offer College Savings Plans.Loans - Unfortunately, the new law also cuts $12.7 billion out of the budget for the federally guaranteed student loan program. It’s estimated that this could cost as much as an extra $2,000 in interest on a $20,000 student loan.

In addition to the "billable" college costs, such as tuition, fees, room and board, keep in mind that there are substantial indirect costs. These include books, supplies, travel and personal expenses.

Fortunately, there are many ways to save and pay for college. Unfortunately, the myriad of options can be confusing and even overwhelming to understand. Which plan is best for your child or grandchild? It depends on a variety of factors including the age of the child, the college selected and the family's assets.

Your financial adviser and tax pro can help you review your assets and put together a plan that might include Section 529 College Savings Plans, Prepaid Tuition Plans, loans, grants, Coverdell Education Savings Accounts, U.S. Savings Bonds and more.

In addition, here are some online resources to help explain the financial issues involved in saving and paying for college:

Pay for College, a comprehensive guide from the College Board, a not-for-profit association that administers the SAT and other programs.

Consider a Credit Card Rebate Program

There are a number of credit card affinity or loyalty programs now available that allow you to accumulate rebates from everyday purchases in a Section 529 college fund. While it's unlikely that these programs will provide a substantial amount of money for most parents, every little bit helps.
How they work: If you spend money at the companies affiliated with the programs, these companies deposit a small percentage of the purchase price into a college fund for your child or grandchild.

Here's a little-known secret for parents planning to send their children to college in the future: Some of the tax-saving moves you make now could hurt your student's chances for getting financial aid later.

It's because of the way the financial aid system treats different assets. Retirement plans and IRAs don't count for college aid purposes under the federal government-mandated formula. You're not expected to break into these accounts to pay for tuition.

A good strategy: If you expect to apply for financial aid, don't hold back placing money in your own retirement plan in order to put away savings in a college account in your child's name.

Contributions to retirement accounts are usually tax-deductible and the earnings are tax deferred until withdrawn. On top of these tax breaks, your family may also become eligible for more financial aid.

Remember that you can usually tap retirement accounts for college money. Many 401(k) plans allow loans to be taken. And thanks to a tax law that went into effect in 1998, you can generally withdraw a limited amount from your IRAs penalty-free to pay higher education costs for yourself, your children and grandchildren.

Don't assume you're not eligible for financial assistance in the form of grants, loans, scholarships and work-study jobs. With the high cost of college today, many schools now have programs available to relatively well-off families if they meet certain qualifications. For example, on its Web site, Harvard states: "Even families with annual incomes exceeding $130,000 (U.S.) may qualify for scholarship aid."

In addition, your child might be able to get "merit awards" based on high standardized test scores and superior grades.

More Important Facts About How Financial Aid is Calculated

The first step in getting financial assistance is to fill out the Free Application for Federal Student Aid (FAFSA). The federal college aid formula requires 35 percent of the assets in your child's name to be used for college costs. But it only expects about 5.6 percent of the money in the parent's name to be spent. So you may be better off keeping accounts in your own name, especially during the last two years of high school, which is generally when you'll be asked to start providing tax returns.
Note: Depending on the school, a different methodology or a combination of formulas may be used to calculate financial aid awards. Parents must fill out the FAFSA and then fill out another form that asks for additional information.

Many private colleges and universities use the Institutional Methodology, which penalizes families with a great deal of home equity but permits more generous treatment of items such as medical expenses, elementary and secondary school tuition and child support payments. It also assumes the student will spend some time each year working to earn money.

A third, relatively new methodology, called the Consensus Approach, is now used by approximately 30 colleges and universities including Yale, Cornell, Stanford, MIT, Columbia, Wellesley and Duke. Among its principles: Students’ assets and parents’ assets are treated the same to discourage families from moving assets between generations.

To make matters more confusing, even if a college uses one of the formulas described above, it can still be flexible when awarding its own money. In other words, when awarding federal grants, loans and most state aid, the federal formula is used but when awarding a school's own awards, each school a student applies to may make calculations differently